It started as a technical trick to get around a political problem. Now it is the political problem.
It's called "the bubble" and it's the income tax anomaly Democrats want to burst as the price for a reduction in the capital gains tax sought by President Bush.
The term refers to the fact that income for upper-middle-income taxpayers is taxed at a higher rate than is the income of wealthier people, under provisions of the 1986 tax reform legislation. A married couple with income between about $78,000 and $185,000 is under the bubble effect, for example.
The bubble is arousing fierce emotions as time runs out for a budget deal before the beginning of the new fiscal year. In a speech to the American Academy of Actuaries yesterday, House Ways and Means Committee Chairman Dan Rostenkowski insisted that bursting the bubble was central to any deal that includes a capital gains tax cut. "It calls on us to defend one of the fundamental principles of our party," the Democrat said, "that those best able to pay for the cost of government should pay the most."
Republicans have proposed a number of alternatives to bursting the bubble, including a plan to limit tax deductions to no more than $50,000, but Democrats keep coming back to the bubble whenever Republicans raise the issue of capital gains cuts or even the indexation of capital gains.
Apparently convinced that any package that bursts the bubble would be rejected by a majority of House Republicans, the GOP House leader openly broke with the Bush administration and said he was willing to abandon the quest for capital gains tax cuts.
Few people present at the creation of the bubble in 1986 envisioned that it would one day be at the center of a budget-blocking dispute.
One of the designers of the device said that it had nothing to do with principle. "There was absolutely no theory behind it at all," he said. "It was solely to satisfy political constraints in coming up with a tax-reform package."
The constraints at the time were that the supporters of tax reform did not want to have an income tax rate greater than 28 percent, and they still wanted the tax structure to be progressive. At the same time, lawmakers needed to find ways to raise more money through taxes to make the landmark tax-reform package work.
So lawmakers designed a bubble: a range in which upper-middle-income earners pay a higher tax rate on every additional dollar of earnings than the wealthiest Americans do. This raised the needed money. But because tax rates phase in gradually, overall average-income tax rates would never rise above a maximum of 28 percent.
The way it works for a married couple filing a joint return in 1990 would be to tax income up to $32,450 at a rate of 15 percent. Their income between $32,450 and $78,400 would be taxed at a rate of 28 percent. Their income between $78,400 and $185,730 would be taxed at a rate of 33 percent. And income beyond that point would be taxed at a rate of 28 percent.
Richard G. Darman and William Diefenderfer, now Nos. 1 and 2 in the Office of Management and Budget, were then two of the architects of the bubble. Leading Democrats went along with the plan.
The result of its design is that the top earners pay only 28 cents for every additional dollar earned while upper-middle-income earners pay 33 cents on every additional dollar earned. Democrats call this unfair and want to extend the 33 percent marginal rate to the highest income bracket.
Republicans have countered with a plan to "flatten" the bubble and tax both upper-middle and wealthy individuals at a 31 percent rate. That plan would be "revenue neutral"; it would neither raise additional money nor cost the government any tax revenue.
But Democrats have pressed for a 33 percent rate as the price to be paid for a capital gains tax cut.
Rostenkowski said yesterday, "We're just looking for a package that is fair, a deficit reduction plan that requires shared sacrifice and shared burdens from all Americans. This call to sacrifice will sound off-key if we include the capital gains measure without sizable new taxes on the rich. How can we convince average Americans to accept such an agreement that dips into their wallets but leaves the wealthy better off than they were before? The answer is we can't convince them and it would be a disgrace to even try."